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Absorption Costing - Overview
1. Overview of Absorption costing and Variable Costing
N
I
.
E
2. Review how costs for Manufacturing are transferred to the product
V
S
3. Job Order Vs. Process Costing
S
.B
4. Overhead Application
- Under applied Overhead
- Over applied overhead
W
W
W
5. Problems with Absorption Costing
6. Concluding Comments
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Absorption Costing
The focus of this class is on how to allocate manufacturing costs to the
product.
- Direct Materials - Direct Labor - Overhead N
I
.
E
V
S
S
.B
Absorption costing is a process of tracing the variable costs of
production and the fixed costs of production to the product.
W
W
Variable Costing traces only the variable costs of production to the
product and the fixed costs of production are treated as period
W
expenses.
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Absorption Costing
There are three different types of Absorption Costing Systems:
- Job Order Costing
- Process Costing
- ABC Costing
N
I
.
E
V
S
In Job Order Costing costs are assigned to the product in Batches or lots.
- Printing
- Furniture manufacturing
- Bicycle Manufacturing
S
.B
W
In Process Costing, costs are systematically assigned to the product, since
there are no discreet batches to assign costs.
- Oil Distilling
- Soda Manufacturing
W
W
ABC Costing assigns cost from cost centers to the product
- Best in a multi product firm, where there are different volumes
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Absorption Costing
A simplified view of Production:
Introduce Raw
Materials
1.
2.
Direct materials
are purchased
Direct materials
are placed into
production
Manufacture
Product
N
I
.
E
1. Direct labor
applied to
product
2. Overhead costs
are incurred
W
W
W
S
.B
V
S
Store finished
goods
Sell Finished
Goods
1. Production process
completed
2. Goods are shipped
for sale
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Absorption Costing
How do we account for the production process?
N
I
.
E
1. Direct materials are purchased and recorded as an asset.
V
S
S
.B
2. As direct materials are placed into production, their cost
is transferred from the raw materials account to the Workin-Process account (an asset)
W
W
3. As direct labor costs are incurred they are recorded in a
labor expense account. Throughout the year they are
transferred from the labor expense account to Work-inprocess account (an asset).
W
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Absorption Costing
4. Overhead costs are initially accumulated in expense
accounts (electricity, depreciation, etc..). Throughout the
year they are transferred to Work-in-process.
N
I
.
E
V
S
5. When goods are completed, their costs (direct materials,
direct labor and overhead) are transferred out of Work-inprocess, and into Finished Goods.
S
.B
W
W
6. When foods are sold, their costs are transferred out of
finished goods inventory (an asset) and into Cost of goods
sold (an expense).
W
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Absorption Costing
Important points to take away from how we account for manufacturing costs:
N
I
.
E
1. Initial expenditures on raw materials, direct labor, and overhead are
CAPITALIZED (recorded as assets) in Work in process and finished goods
inventory.
V
S
S
.B
2. They are transferred to expense accounts when the finished goods are sold
(they go to cost of goods sold).
W
3. Generally the cost of goods manufactured, (the costs incurred in
manufacturing the product) will not equal the cost of goods sold.
W
W
- This means that in any year some of the costs associated with manufacturing
the product will not flow through the income statement as an expense, they
will remain in the inventory accounts as assets!
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Absorption Costing
Consider the following example:
N
I
.
E
A company is formed to manufacture computers. It starts
the year with $2000 in cash and equity. During the year the
company incurs $500 in payroll costs, $500 in rent for the
plant, and $500 in raw materials. During the year he
makes 100 computers.
V
S
S
.B
W
W
What will his profits (or loss) be if he sells no computers?
W
What will his profits be if he sells all 100 computers at $20
per computer?
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Job Order Costing
Job Order Costing is one method of allocating the costs of manufacturing to
the product.
N
I
.
E
In Job order costing the manufacturing costs are allocated to the product by
batch.
V
S
S
.B
Job order costing is appropriate when the firm makes products in small
batches, and each batch consumes different amounts of direct labor, direct
materials, and processing time/energy.
W
A survey in “Cost and Management Accounting Practices..” in the Management
Accounting Research Centre indicate that job order costing is the primary method of
costing in the following industries:
- Electorics
- Machinery
- Computers
- Furniture and fixtures
W
W
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Job Order Costing
N
I
.
E
Consider a computer manufacturing company. They have a plant that
receives an order for 50 computers. They need to determine how
much it costs to manufacture these computers.
V
S
The batch of 50 computers starts with the introduction of direct
materials:
S
.B
W
- 50 Computer Cases
- 50 Motherboards
- 50 CD drives, and floppy drives
W
W
Individuals mount equipment, add additional memory etc, to meet the
specifications of the job.
Special machines are also used to attach the disk drives.
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Job Order Costing
In Job order costing the manufacturing costs are allocated to the product by
batch. Thus the company allocates manufacturing costs to the 50 Computers
ordered.
The Job is assigned a Lot #. Lets call this Lot # 1118.
N
I
.
E
V
S
S
.B
When the Parts warehouse provides 50 motherboards, cd roms etc… to the
manufacturing group, they allocate the costs of these raw Materials to LOT
#1118.
W
The individuals that assemble these computers record the time spent
assembling Lot 1118 on their time sheets. The accounting system will allocate
the payroll costs at the hourly wage rate to the job.
W
W
Finally, the cost of the plant, the cost of the specialized machines, the utilities,
the accounting system that tracks costs within the plant, the accountant
running the system etc… must be allocated to the product. This is known as
overhead allocation.
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Job Order Costing
Lot # 1118
N
I
.
E
Direct Materials:
50 Motherboards @ $200 per board
$10,000
50 Floppy Disk Drives @ $50 per drive
$ 2,500
V
S
50 CD Rom drives @ $20 per dirve
S
.B
50 Cases @ $20 per case
Total Direct Materials
W
Direct Labor and Overhead
$ 1,000
$ 1,000
$14,500
Employee #4323 40 hours @ $25 per hour
$1,000
Overhead Allocation $100 per direct Labor hour
$4,000
W
W
Total Direct Labor and Overhead
$5,000
Total Cost
$19,500
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Job Order Costing
A natural question to ask with this example, is how do we determine
the overhead allocation rate?
N
I
.
E
1. Estimate total Overhead for the plant for the year.
V
S
S
.B
2. Select an activity base to allocate overhead costs to the product.
3. Estimate expected usage of the activity base.
W
W
4. Overhead allocation Rate = Estimated Overhead Costs
Estimated Activity Base
W
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Job Order Costing
Suppose the company estimates overhead costs for the
plant to be to be $1,000,000 and direct labor hours to be
1000 hours.
N
I
.
E
V
S
What is the overhead application rate?
S
.B
What happens if the employees only work 900 hours?
W
What happens if the employees work 1100 hours?
W
W
What happens if the price of heating oil is greater than expected?
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Job Order Costing
What happens to the under or over applied overhead?
N
I
.
E
1. Write-off directly to cost of goods sold.
V
S
S
.B
2. Write off proportionately to WIP, Finished goods and
Cost of goods sold.
W
W
3. Re-allocate costs to all products to “correctly” allocate
overhead to WIP, Finished goods, and Cost of goods sold.
W
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Rosen Corp (Problem 9-4)
See the exercise “Rosen Corp.”: Problem 9-4 in Zimmerman,
Jerold L. Accounting for Decision Making and Control (4th Edition).
McGraw-Hill/Irwin, 2002, pp 478-9.
N
I
.
E
V
S
S
.B
W
W
W
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Process Costing
A process cost system is used when a manufacturing
company makes large volumes of identical products.
(pharmaceuticals, bottles of Pepsi, gallons of oil)
N
I
.
E
V
S
Each unit consumes the same amount of direct materials,
direct labor and indirect costs (overhead)
S
.B
W
Instead of assigning costs to jobs, then averaged across the
job to get a per unit cost, process costing assigns costs to
the product through each process the product goes through.
W
W
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Process Costing
Consider a Cola Manufacturer Mixing
Bottling
N
I
.
E
Distribution
V
S
S
.B
W
W
Direct materials (sugar, water, coloring)are mixed.
They are poured into a bottle.
Carbonation is added.
They are capped.
W
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Process Costing
How does process costing differ from job costing?
N
I
.
E
V
S
Survey indicates that Process
costing is most
S
often used in the following
.B industries:
W
W
W
1.
2.
3.
4.
Oil refining (100%)
Chemicals
Pharmaceuticals
Food and Beverage
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Absorption Costing - Problems
1. In an absorption cost system such as Job order costing,
what happens to plant profitability if additional output is
produced and not sold?
N
I
.
E
V
S
S
.B
2. Suppose you allocate overhead using direct labor hours,
and a special order comes in that requires the factory be
completely recalibrated, to process the job. Will this cost
be traced back to the job?
W
W
W
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Variable Costing
N
I
.
E
Variable costing tries to reduce the incentive to over
produce by charging fixed overhead costs to expense in the
period they are incurred, and allocating only variable costs.
V
S
S
.B
Increasing production does not allow a firm to move fixed
costs out of COGS and into inventory.
W
W
W
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First Eastern Bank (problem 9-13)
See the exercise “First Eastern Bank”: Problem 9-13 in
Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 483-4.
N
I
.
E
V
S
S
.B
W
W
W
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Frames Inc (problem 9-23)
N
I
.
E
See the exercise “Frames Inc.”: Problem 9-23 in Zimmerman,
Jerold L. Accounting for Decision Making and Control
(4th Edition). McGraw-Hill/Irwin, 2002, pp 491-2.
V
S
S
.B
W
W
W
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Summary
1. Discussion of Absorption costing
- Strengths and weaknesses
- How is it done.
- Potential Solutions to some of the problems.
N
I
.
E
V
S
S
.B
2. Reviewed how we account for manufacturing costs Highlighted
how manufacturing costs are transferred to the product
W
3. In depth coverage of Job Order Costing and Overhead application
W
W
4. Set up discussion of ABC costing
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Overview
1.
2.
3.
4.
5.
6.
Basinger vs Main Line
Terminology
Cost Drivers
Breakeven Analysis
Other problems
Summary
N
I
.
E
V
S
S
.B
W
W
W
1
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Basinger vs Mainline
To read the Basinger vs. Mainline case, see:
N
I
.
E
Barton, Thomas L., William G. Shenkir and Brian C. Marinas.
Instructional Case - Main Line vs. Basinger: A Case in Relevant
Costs and Incremental Analysis. Issues in Accounting
Education. Sarasota: Spring 1996. Vol. 11, Iss. 1, pp 163, 2 pgs.
V
S
S
.B
W
W
W
2
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Cost Behavior
N
I
.
E
How do total costs change with changes in units of
production?
Total Cost
V
S
S
.B
W
W
W
Quantity
3
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Cost Behavior
N
I
.
E
How do per unit costs change with changes in volume?
V
S
Total Cost
S
.B
W
W
W
Quantity
4
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Terminology
Fixed Costs
Variable Costs
Average Costs
Period Costs
Product Costs
N
I
.
E
Direct costs
Indirect Costs
V
S
Marginal Costs
S
.B
Opportunity Costs
Sunk Costs
Avoidable Costs
W
W
Direct Materials
Direct Labor
Overhead
W
5
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Cost Drivers
• Up until this point we have focused on how costs change
with changes in output or units sold.
N
I
.
E
V
S
• There are other “cost drivers” that may better describe the
behavior of a cost than the output of the manufacturing
process.
S
.B
W
• Consider the following manufacturing process for insect
traps (which I was involved in as an undergraduate.)
W
W
6
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Cost Drivers
Most insect traps work because of Pheromones.
N
I
.
E
Each insect has a different Pheromone, thus to make a
particular type of insect trap, you need to mix different
chemicals.
V
S
S
.B
We can break up the production process into the following
activities.
W
W
To make an insect trap you must:
1. Set up for mixing
2. Mix chemicals
3. Kiln chemicals
4. Make the traps.
W
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Cost Drivers
To set up to mix 16 ounces to 1600 ounces of a pheromone
for kilning takes 50 hours of labor @ $20 per hour.
N
I
.
E
An individual Kiln can only handle up to 100 pounds of a
pheromone, then a new kiln has to be setup.
V
S
S
.B
Thus setup costs are fixed cost for up to 100 pounds of a
pheromone.
W
W
So how much would it cost (in terms of labor dollars) to
make 250 lbs of fruit fly pheromone?
W
8
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Cost Drivers
What was your first inclination to do in calculating
the cost of making the fruit fly pheromone?
N
I
.
E
V
S
What happens in costing this product when we add
layers to the production process like assembly,
disposal, shipping, receiving?
S
.B
W
ABC costing
suggests that instead of tracking setW
up costs per pound of pheromone, it makes pore
W
sense to track set-up costs per batch kilned.
9
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Breakeven Analysis
Consider the following format of the income statement
Revenues
-Variable costs
Contribution Margin
-Fixed Costs
Profit
N
I
.
E
V
S
S
.B
W
W
Where the contribution margin equals fixed costs, we have
hit the break even point.
W
If we have some desired profit level, we can “work
backwards” to determine the number of units we need to
produce and sell to reach the desired profit.
10
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Operating Leverage
Operating Leverage represents the ratio of fixed costs to
total costs.
N
I
.
E
V
S
Firms with higher operating leverage will experience
relatively larger changes in income when there are changes
in volume.
S
.B
W
W
This because firms with more operating leverage have
relatively larger per unit contribution margins.
W
11
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Amy’s Boards (Prob 2-41)
See the exercise “Amy’s Boards”: Problem 2-41
in Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 94-5.
N
I
.
E
V
S
S
.B
W
W
W
12
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Emrich Processing
N
I
.
E
See the exercise “Emrich Processing”: Problem 2-11
in Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 75-6.
V
S
S
.B
W
W
W
13
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X Corporation Jet (Prob 2-16)
The exercise “X Corporation Jet” is not available in the fourth edition
of the textbook (the one this class uses). It can be found in the third
edition:
N
I
.
E
V
S
Problem 2-16 in Zimmerman, Jerold L. Accounting for Decision
Making and Control (3rd Edition). McGraw-Hill/Irwin, 1999, pp 68.
S
.B
W
W
W
14
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Eastern University (P2-26)
See the exercise “Eastern University”: Problem 2-26
in Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 84.
N
I
.
E
V
S
S
.B
W
W
W
15
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Summary
1.
Focus on how managerial accounting information is used
in a decision making process:
- Incremental analysis
- Contribution margin
- Break even analysis
2. Review of cost terminology
3. Highlight the importance of relevant range, and cost
drivers
4. Once again reinforce the idea that we need to
“Be aware of reported costs”
N
I
.
E
V
S
S
.B
W
W
W
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Balanced Scorecard
Assignment:
1.
Outline the central concepts to the balanced
scorecard.
2.
Develop a balanced scorecard for M.I.T’s Sloan
School of Business.
N
I
.
E
-
V
S
Mission Statement
Strategies to accomplish mission or value
statement.
Select performance measures from four perspectives.
S
.B
W
W
W
3.
In your proposed system should compensation be
linked to performance? If so whose
compensation?
4.
How effective do you think the balance
scorecard would be in an academic institution
like MIT?
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Budgeting - Overview
1. Budgets as a mechanism of partitioning decision rights and as a
mechanism for control.
- Decision management
- Decision control
2. Incentives
- Performance measurement
- Compensation
- Horizon problem
- Perverse Incentives
N
I
.
E
V
S
S
.B
W
W
3. Types of budgets
- Line Item Budgets
- Lapsing Budget
- Flexible Budget
- Zero based budgets
- Incremental Budgets
W
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Budgeting
Theoretically, budgets serve two roles:
N
I
.
E
1. Allocate Decision Rights:
- Decision Initiation – Budget Preparation
- Decision Implementation – Operating Decisions
V
S
S
.B
2. Control Behavior
W
- Decision Ratification
- Decision Monitoring
W
W
Budgets are also used as a method of measuring
performance, a mechanism to plan expenditures, and to
reward performance.
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Budgeting
Let’s make sure we know what budgets are from a practical
perspective:
N
I
.
E
1. They are plans for 1 to 10 years for all of the business units.
V
S
2. The budgets serves as a mechanism for coordinating production and
sales
S
.B
3. Estimates are compared to actual as a means of evaluating
performance.
W
W
4. Budget variances are often used as a means of punishing and
rewarding behavior.
W
5. Budgets are updated to reflect outcomes.
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Budgeting
Firms often use budgets to measure the performance of managers.
N
I
.
E
V
S
When budgets are used to measure performance we need to think about the concepts of:
S
.B
- Controllable Variances
W
W
- Uncontrollable Variances
W
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Rosebud (Prob 6-28)
N
I
.
E
See the exercise “Old Rosebud Farms”: Problem 6-28 in
Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 316-7.
V
S
S
.B
W
W
W
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Budgeting
We also need to think about how do you account for
volume effects?
N
I
.
E
V
S
What happens when there is a reduction in volume?
S
.B
W
Does it matter if it is controllable?
W
W
- Static vs. Flexible Budgets.
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Golf World (prob 6-9)
See the exercise “Golf World”: Problem 6-9 in Zimmerman,
Jerold L. Accounting for Decision Making and Control (4th
Edition). McGraw-Hill/Irwin, 2002, pp 301-2.
N
I
.
E
V
S
S
.B
W
W
W
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Budgeting -Textbook sales
When budgets are used to measure performance, they are also often used in the
compensation scheme.
N
I
.
E
Consider the following compensation scheme used in textbook sales.
V
S
The head office forecasts sales for each sales territory using the ratcheting
principle.
S
.B
The sales rep prepares a budget for complementary books and over night visits
that is approved by the head office.
W
Sales reps are compensated a fixed salary and receive a fixed bonus for
reaching their budgeted revenues
They receive a small fractional increase bonus money for each dollar of sales
generated over the budgeted amount through 110% of the budget
W
W
Larger bonuses if budgeted revenues are exceeded by more than 10%.
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Budgeting -Textbook sales
What are the sales rep’s incentives?
N
I
.
E
V
S
What mechanisms does the sales rep have to influence
actual outcomes
S
.B
W
What do you think the sales pattern of a textbook rep looks
like over time?
W
W
What incentives does the rep have if incentive pay is based
on budgeted income instead of budgeted revenue?
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Budgeting
Types of Budgets
N
I
.
E
1. Line item budgets
V
S
2. Lapsing Budget
3. Zero based budgets
S
.B
W
W
4. Incremental Budgets
W
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Budgeting
What is a line item budget?
N
I
.
E
How are decision rights allocated in line
item budgets?
V
S
S
How does a line item
budget control
B
.
behavior?
W
W
What W
incentives do line item budgets
provide?
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Budgeting
What is a lapsing budget?
N
I
.
E
How are decision rights allocated in lapsing
budgets?
V
S
S
How does a lapsing.B
budget control
behavior?
W
W
What W
incentives do lapsing budgets
provide?
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Budgeting
What is a zero based budget?
N
I
.
How are decision rights allocated in E
zero based V
budgets?
S
S
B
.
How does a zero based budget control behavior?
W
W
What incentives
W do zero based budgets provide?
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Budgeting
What is an incremental budget?
N
I
.
How are decision rights allocated in incremental
E
budgets?
V
S
S
.Bbudget control How does an incremental
W
behavior?
W
W do incremental budgets provide?
What incentives
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Budgets - Summary
Budgets are an important mechanism in the allocation of decision rights.
N
I
.
Budgets are often used to measure performance
E
V
S
Budgets are also used as a S
mechanism for control.
B
.
Wbetween decision control and There is a tradeoff
W
decision management
W
Identify the strengths and weaknesses of various
types of budgets.
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Cost Allocations – Overview
1. Motivation for the importance of cost allocations.
2. How do we allocate costs?
N
I
.
E
V
S
S
.B
3. Effects of cost allocations?
W
4. Examples
W
W
5. Concluding comments
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Why are cost allocations important?
Consider the apartment you shared with someone that was
not related to you, how did you pay for the following?
N
I
.
E
V
S
- Rent
- Phone
- Food
- Electric
- Cable
- Gas
S
.B
W
W
Does the method you allocate costs matter? Why? W
Will the method you select affect the total cost incurred? www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
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Cost Allocations
Consider a very simple example where an individual buys an office
building and rents the building to tenants.
N
I
.
E
The owner of the office building has a problem. She has to pay for
common area maintenance costs such as:
-
V
S
S
.B
Lighting and heating in the lobby and halls
Snow removal and parking lot maintenance.
Security
Building Management
Roof maintenance
Property taxes
W
W
W
All of the tenets in the office building benefit from these expenditures.
What should the manager do?
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Cost Allocations
1. What happens if the manager does not charge
the tenants for these costs?
N
I
.
E
V
S
2. What happens if the manager charges an
average rate per tenant?
S
.B
W
3. How are these costs consumed? What is the
cost object?
W
W
4. What costs need to be assigned?
5. How would you assign them?
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Cost Allocations
How would you assign the costs of a
maintenance department to the tenants of
the building?
N
I
.
E
V
S
S
Why doesn’t the tenants
B rent include a
.
CAM charge? W
Why is this separate from
the rent? W
W
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Cost Allocations
Now think of the firm as the office building and each of
the tenants as a product the firm manufactures.
N
I
.
E
V
S
Common area costs include the cost of the plant, the
payroll department, the janitorial staff, the benefits office,
the accountants, etc…
S
.B
W
W
These costs must be allocated to the products.
W
How the costs are allocated is going to affect the profits of
the entire firm, and the behavior of the manager.
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Why Allocate Costs
- Third Party reimbursements
- Rate regulated industries
- Governmental subsidies
- Cost plus contracts
N
I
.
E
V
S
S
.B
W
- External Reporting/Taxes
- FASB and IRS requires allocation.
W
W
- Costing products accurately is important.
- Decision Making
- Control
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Cost Allocations
Southwestern Bell Telephone Co. has acknowledged that
some Washington lobbying expenses incurred by its parent
corporation were improperly included in the company's
regulated interstate rate base.
N
I
.
E
V
S
The lobbying expenses totaled about $1.4 million over a
five-year period and included money spent to promote
changes in the Modified Final Judgment, according to
documents submitted this month to the Federal
Communications Commission.
S
.B
W
W
W
Charles Mason 04/30/1990
Telephony COPYRIGHT 1990 Intertec Publishing
Corporation
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Cost Allocations
As part of its costs related to treating Medicaid patients, St.
Elizabeth Medical Center in Covington included $13,466
for Cincinnati Reds box seats. Owensboro-Daviess County
Hospital included a $35,000 payment to settle a sexualharassment case against a doctor. And Columbia Suburban
Hospital in Jefferson County put down $117,700 worth of
free meals for doctors. These were among the expenses
that Kentucky hospitals submitted as part of their costs in
reports to the state Medicaid program.
N
I
.
E
V
S
S
.B
W
W
W
KAY STEWART, The Courier-Journal 10/06/1996
The Courier-Journal
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Cost Allocation
According to Strategic Cost Management, Free Press,
1993.
N
I
.
E
V
S
There is a billion-dollar-a-year market in strategic cost
management consulting services dominated by such
firms as Bain & Company, Boston Consulting Group,
Booz-Allen & Hamilton, McKinsey etc.
S
.B
W
W
W
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Cost Allocation
N
I
.
E
There are also consulting firms that develop niche groups
that are experts in cost allocations for example:
V
S
Brattle Group – Energy Department
S
.B
We address the economic and financial issues raised by the
allocation of costs over time or among different services
and customers.
W
W
W
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What costs are allocated?
In a single product firm, that has one customer, and only one division
there is no need to worry about cost allocations.
Most companies are:
- Multi Divisional
- Offer a variety of Products
- Thousands of Customers
N
I
.
E
V
S
S
.B
W
Divisions, products, and customers consume common costs at different
rates, or in different amounts.
W
W
An effective cost allocation system will more accurately trace the
shared costs of production to the divisions, products and customers that
consume those costs.
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What are the common Costs of production ?
Overhead
1.
2.
3.
4.
5.
N
I
.
E
V
S
How are overhead costs consumed in the plant?
Can these costs be traced back to products?
What costs can and can not be traced back to individual products?
- Electricity
- Maintenance
- Plant costs
- Benefits department
- CEO time
- Customer service
How do we allocated the costs that can not be traced back to the
product?
Does the method used to allocate these costs matter?
S
.B
W
W
W
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Cost Allocations
The method of allocating costs and the amount of costs allocated are
important for the following reasons:
N
I
.
E
1.
The method of allocating costs will determine the use of common
assets.
V
S
S
.B
- Internal Taxation
- Internal Subsidization
W
2. The method of allocation may also affect whether divisions
compete or coordinate.
W
W
- Insulating Allocation
- Non-insulating allocation.
3. Cost allocations affect performance and compensation.
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Jolsen International
(Prob 7-7)
N
I
.
E
See the exercise “Jolsen International”: Problem 7-7 in
Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 362-3.
V
S
S
.B
W
W
W
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Bio Labs (Prob 7-13)
See the exercise “Bio Labs”: Problem 7-13 in Zimmerman, Jerold
L. Accounting for Decision Making and Control (4th Edition).
McGraw-Hill/Irwin, 2002, pp 368.
N
I
.
E
V
S
S
.B
W
W
W
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Nixon and Ross (prob 7-19)
See the exercise “Nixon and Ross”: Problem 7-19 in Zimmerman,
Jerold L. Accounting for Decision Making and Control (4th Edition).
McGraw-Hill/Irwin, 2002, pp 373-5.
N
I
.
E
V
S
S
.B
W
W
W
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Cosmo Inc (Prob 8-3)
N
I
.
E
See the exercise “Cosmo Inc.”: Problem 8-3 in Zimmerman,
Jerold L. Accounting for Decision Making and Control
(4th Edition). McGraw-Hill/Irwin, 2002, pp 417-8.
V
S
S
.B
W
W
W
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Cost Allocations Part I - Summary
1. Cost allocations are important for a variety of reasons.
N
I
.
E
2. The methods used to allocate costs can influence a
manager’s behavior:
V
S
S
.B
- Tax on a particular activity
W
- Insulate manager
W
- Subsidize the use of common assets.
W
3. Start on how cost allocations are done.
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Methods of Allocating Costs - Overview
1. Review the three Method of Allocating Costs.
- Direct Method
- Step Down Method
- Reciprocal Method
N
I
.
E
V
S
S
.B
2. Discuss the strengths and weaknesses of each method
W
3. Winery Problem – platform for discussing Joint Cost
Allocations
W
W
4. Review remaining cost allocation problems.
5. Summarize and Review.
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State College Community Hospital
State College Community Hospital has 2 Service Departments:
1. Maintenance
2. Food Services
N
I
.
E
V
S
The Hospital also has three patient care units:
1. General Medicine
2. OB
3. Surgery
S
.B
W
W
Using the following information, we will allocate the costs of these 2
service departments to the 3 patient care units using the:
1. Direct Method
2. Stepdown Method – Maintenance First
3. Stepdown Method – Food Services First
4. Reciprocal Method
W
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State College Community Hospital
N
I
.
E
Amount of Cost to be allocated:
Maintenance
Food Services
$8,000,000
$3,000,000
Allocation Methods:
V
S
S
.B
W
W
Maintenance Costs are allocated based on square footage assigned to the unit. W
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State College Community Hospital
N
I
.
E
Expected Utilization Rates
V
S
Sq Footage
S
.B
Meals
Served
10,000
30,000
10,000
10,000
20,000
40,000
30,000
30,000
General Medicine
30,000
90,000
Total
100,000
200,000
Food Services
Maintenance
W
Surgery
W
OB
W
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State College Community Hospital
N
I
.
E
Allocate Based on Direct Method
Allocated
Maintenance
Costs
S
.B
W
Maintenance
OB
Allocated
Food Service
Costs
W
Food Services
Surgery
V
S
W
General Medicine
Total
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State College Community Hospital
How do we allocate costs using the Direct Method?
N
I
.
E
1. All Costs of the Service Departments are allocated to
the product.
V
S
S
.B
2. Calculate Expected Utilization Rates
Maintenance
W
Surgery
W
OB
W
General Medicine
Food Service
25%
25%
37.5%
18.75%
37.5%
56.25%
3. Multiply Expected Utilization Rate and amount of cost to
be allocated.
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State College Community Hospital
N
I
.
E
Step-Down Method Maintenance First
Allocated
Maintenance
Costs
S
.B
W
Maintenance
OB
Allocated
Food Service
Costs
W
Food Services
Surgery
V
S
W
General Medicine
Total
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State College Community Hospital
How do we allocate costs using the Step-Down Method allocating
Maintenance First?
N
I
.
E
1. All Costs of the Maintenance Department’s to the four other
divisions in the firm.
2. Calculate Expected Utilization Rates
S
.B
Department
Expected use
Food Services
1/9
Surgery
2/9
OB
Allocated Cost
W
W
W
General Medicine
V
S
3/9
3/9
3. Multiply Expected Utilization Rate and amount of cost to be allocated.
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State College Community Hospital
4. Then take the cost of Food Services + the allocated cost of
Maintenance and allocate those costs to the patient care departments.
Food Services
Allocated Maintenance
Adjusted food service cost
3,000,000
888,888
3,888,888
W
W
Surgery
OB
W
V
S
S
.B
Expected Use
N
I
.
E
Allocated Cost
25%
18.75%
General Medicine
56.25%
Total
100%
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State College Community Hospital
N
I
.
E
Step-Down Method Food Service First
Allocated
Maintenance
Costs
S
.B
W
Maintenance
OB
Allocated
Food Service
Costs
W
Food Services
Surgery
V
S
W
General Medicine
Total
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State College Community Hospital
How do we allocate costs using the Step-Down Method allocating
Food Service First?
N
I
.
E
1. All Costs of the Food Service Department’s to the four other divisions
in the firm.
S
.B
2. Calculate Expected Utilization Rates
Department
Expected use
Maintenance
1/17
W
Allocated Cost
W
Surgery
OB
V
S
4/17
W
General Medicine
3/17
9/17
3. Multiply Expected Utilization Rate and amount of cost to be allocated.
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State College Community Hospital
4. Then take the cost of Maintenance + the allocated cost of Food
Services and allocate those costs to the patient care departments.
Maintenance
Allocated Food Service
Adjusted food service cost
8,000,000
176,470
8,176,470
W
Surgery
W
OB
W
General Medicine
Total
25%
V
S
S
.B
Expected Use
N
I
.
E
Allocated Cost
37.5%
37.5%
100%
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State College Community Hospital
Reciprocal Method:
N
I
.
E
1. Determine total cost to be allocated for each department.
M = 8,000,000 + .10(M) + .05(F)
F = 3,000,000 + .15(F) + .10(M)
V
S
S
.B
Maintenance = $9,144,722
Food Service = $4,605,000
W
W
2. Assign Costs Based on utilization rates for each department
W
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State College Community Hospital
Maintenance:
N
I
.
E
Expected Use
Allocated Cost
Surgery
20%
?
OB
30%
?
General Medicine 30%
?
Total
V
S
S
.B
80%
?
W
Food Service:
W
Expected Use
Allocated Cost
Food + Maintenance
W
20%
?
?
15%
?
?
General Medicine
45%
?
?
Total
80%
?
?
Surgery
OB
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Direct Cost Allocation
Strengths:
1. Easy to Calculate
2. Easy to Implement
N
I
.
E
V
S
S
.B
Weaknesses:
1. Misstates Opportunity Costs
2. Does not charge service departments for the use of
other service departments
W
W
W
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Step-Down Allocation
Strengths:
1. Reduces the subsidization of service department
use of other service departments
N
I
.
E
V
S
S
.B
Weaknesses:
1. Misstates Opportunity Costs
2. Some service departments are not charged for the
use of other service departments.
3. Selection of which department is allocated first
results in different cost allocations.
W
W
W
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Reciprocal Method
Strengths:
1. Theoretically correct method of allocating costs
2. Closest measurement of opportunity cost
N
I
.
E
V
S
S
.B
Weaknesses:
1. Seldom Used because math is misunderstood
2. Assumes all costs are variable, fixed costs should be
allocated based on expected use, which introduce problems
we have already discussed.
W
W
W
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Joint Costs
1. Joint costs are similar to common costs, but instead of an assembly
process we are talking about a disassembly process.
N
I
.
E
2. Be very Careful in using Joint Cost allocations in :
- Pricing Decisions.
- Product Line profitability
V
S
S
.B
3. Use Net Realizable Value (NRV) for decisions on product line
profitability such as:
W
W
W
- Process beyond split-off.
- Sell at split-off
- Discard as waste
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Net Realizable Value
Net realizable value is the same ides as a contribution
Margin:
N
I
.
E
V
S
Total
Selling Price
- Costs Incurred
beyond Splitoff
Net Realizable Value
- Allocated Joint Cost
Profits
100
80
20
10
10
S
.B
W
W
W
Product A
Product B
70
30
55
15
7.5
7.5
25
5
2.5
2.5
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Net Realizable Value
Decision Rules for Net Realizable Value:
1.
N
I
.
E
If total NRV exceeds total allocated joint costs you should incur the
joint costs and disassemble the product.
V
S
S
.B
2.
If NRV for a product is positive consider incurring costs beyond
split-off.
3.
Compare the NRV to the selling price without additional processing.
If NRV greater than selling price without additional processing, then
incur additional processing.
W
W
W
4.
If NRV is negative, compare NRV to disposal cost. Choose the
least costly option.
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Summary
1. Cost Allocations are important
- Performance Measurement
- Decision Making
- Internal Tax
- Subsidy
N
I
.
E
V
S
S
.B
2. Review of how to calculate allocations using Direct
Method, Reciprocal Method, and Step-Down Method.
W
W
W
3. Strengths and Weaknesses of each method.
4. Role of NRV in Joint Cost Decisions
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Overview
•
•
•
•
•
•
Introductions
Overview of class
Course requirements
Introduction to managerial accounting
The Smith Center
Summary
N
I
.
E
V
S
S
.B
W
W
W
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Introduction
•
•
•
•
•
•
Undergraduate degree from Bucknell University
2 years at Price Waterhouse (CPA)
4 years at the Equitable
Ph’d from Penn State
Married with two children
Research Interests
N
I
.
E
V
S
S
.B
W
W
– Accounting for Mergers and Acquisitions
– Role of accounting information in financial contracts.
W
• Experience with managerial accounting
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Course Overview - Objectives
N
I
.
E
1. Become familiar with what accounting information is
typically used within the firm.
- Strategic implications - Limitations V
S
S
.B
2. Develop an understanding of how accounting
information is used by managers in the decision making
process.
W
W
3. Consider how accounting information can be used to
motivate members of the firm or as a mechanism to control
their behavior.
W
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Course Overview – Who should take this class
Are you going to be a manager?
N
I
.
E
V
S
Are you going to be a consultant?
S
.B
W
Are you going to be an entrepreneur?
W
W
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Course Overview - Requirements
This class is designed to allow you to develop an
understanding of the concepts by applying the material
covered to real life problems and cases. I have designed
the grading system for this class to meet this objective.
N
I
.
E
V
S
S
.B
Your grade will be computed as follows:
Group Case
Individual Cases
Take home Final
W
W
W
20%
40%
40%
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Course Overview
Throughout the course we will develop an understanding of
three basic concepts:
N
I
.
E
1. How costs behave
V
S
S
.B
2. The nature of the firm
W
3. How accounting systems report costs
W
W
These building blocks will be used to gain insights on the role
of accounting information in a variety of settings.
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Managerial Accounting
What is managerial accounting?
N
I
.
E
V
S
S
.B
W
W
W
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The Smith Center
N
I
.
E
In 1992, State University committed to building the Smith Center (A
15,000 seat basketball Arena). The following projected financial
information was available to the University prior to engaging in the
project:
V
S
S
.B
Costs:
Building
Parking
W
W
W
Funding:
Private Contributions
State Funding
$54 million
$ 2 million
$23 million $33 million www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
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The Smith Center
In the year after the Smith Center was built there were conflicting
stories on the profitability of the Smith Center, and the profitability of
the athletic department.
N
I
.
E
V
S
The state legislature reported that the athletic department made over 18
million and the basketball program made over 2.2 million.
S
.B
The University reported a marginal profit for the basketball program,
and breakeven results for the entire athletic department.
W
W
How can there be two different “profits” for the same economic entity?
W
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The Smith Center
N
I
.
E
The following is a hypothetical scenario
describing how these could be two different
measurements of profit for the same
economic entity. Lets first focus on the
universities estimate.
V
S
S
.B
W
W
W
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The Smith Center
State University’s estimates on Profitability of the Smith Center: Revenue:
Basketball Ticket Revenue
Parking
Donations to Basketball program
Television Revenue
Allocated shared revenue
Costs
Utilities
Tuition cost of supporting a
basketball team
Cost of supporting coaches
and administrators:
Payroll Costs
Allocation of shared expenses
W
V
S
S
.B
W
W
$2 million
$.5 million
$1 million
$2.2 million
$.2 million
N
I
.
E
$1 million
$810,000
$700,000
$200,000
$1 million
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The Smith Center - Factors
What are allocated Costs?
- Orthopedic Surgeon
- Team Physicians
- Trainers
- Athlete medical Expenses
- Sports Information Department
- Academic Support Center
N
I
.
E
V
S
S
.B
W
These cost total $23 million and are allocated equitably over the 23
varsity programs.
W
W
What would happen if the allocation were changed to a per athlete
basis?
Does it matter?
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The Smith Center - Factors
What are allocated revenues?
N
I
.
E
State University has a 4.2 million dollar endorsement
contract with Pepsi. This revenue is also allocated
equitably over the 23 Varsity programs.
V
S
S
.B
Does an equitable allocation make sense?
W
What happens if the allocation is changed to sports which
are broadcast to a national audience, or the number of
national appearances?
W
W
Does it matter?
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The Smith Center - Factors
N
I
.
E
What are the opportunity costs of providing $56 million of financing
for the Smith Center?
V
S
S
.B
Develop a school of information technology.
Expand the library.
W
W
W
Expand the football stadium
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The Smith Center - Factors
N
I
.
E
How are utility costs assigned to the team?
V
S
In the Smith Center there are only 3 teams that use the facility, men’s
and women’s basketball and wrestling. In Rec Hall 15 teams use the
facilities.
S
.B
W
Basketball and wrestling are winter sports, how are utility costs for the
rest of the year assigned?
W
W
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The Smith Center - Factors
N
I
.
E
Can State University generate additional revenue at the Smith Center?
-
V
S
Concerts
WWF
Product Expo
S
.B
W
Will State University use the facility for other purposes?
-
W
W
Commencement
Job Fair
Tail gates etc…
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The Smith Center - Factors
N
I
.
E
How do you allocate the costs of the 56 million dollars raised since
there is no interest associated with raising these funds?
V
S
S
.B
- Cost of Debt?
- Cost of Equity?
W
W
W
- Cost of next best available alternative?
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The Smith Center
N
I
.
E
Should State University open the Smith
Center?
V
S
S
.B
Important considerations:
W
W
W
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Summary
N
I
.
E
Important Concepts to take away from this class:
1. Opportunity Costs
V
S
S
.B
2. Cost allocations are important in a wide variety of contexts.
3. Incremental cost analysis.
W
W
For tomorrows class, please read Main line vs Bassinger, it is on the
web, and skim chapter 2 of the textbook. We will spend some time on
problems: 2-16 (X Corporation Jet), 2-26 (University Parking), 2-41
(Amy’s Boards).
W
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Performance Measurement and Transfer Pricing
1.
Performance Measurement
- Cost Center
- Profit Center
- Investment Center
2.
Controllability Principle
3.
Transfer Pricing
- Market Based
- Variable Cost
- Full Cost
- Negotiated Transfer
N
I
.
E
V
S
S
.B
W
W
W
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Allocation of Decision Rights
As we discussed on Monday, in firms owners often have to
allocate decision rights to managers.
Firms are often divided into subunits.
N
I
.
E
V
S
S
.B
The decision rights assigned to a subunit are used to
classify the unit as a:
W
W
1. Cost Center
2. Profit Center
3. Investment Center
W
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Cost Centers
Decision rights
1. labor
2. Supplies
3. Materials
Performance measures
N
I
.
E
V
S
S
.B
1. Minimize total cost for a selected level of output.
W
2. Maximize total output for a given budget.
W
W
Problems:
Quality for Quantity Tradeoff
Average cost crates incentive to overproduce
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Profit Centers
Decision Rights
1. Input Mix (see Cost Centers)
2. Product Mix
3. Selling Price
N
I
.
E
V
S
S
.B
Performance Measurement
W
- Accounting profits compared to budget or some expectation.
Problems
W
W
- Interdependencies of profit centers.
- Transfer Pricing
- Cost Allocation
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Investment Centers
Decision Rights:
1.
2.
3.
4.
N
I
.
E
Input Mix
Product Mix
Selling Prices
Capital Investment
V
S
Performance measures
1.
2.
3.
4.
S
.B
W
W
Net Income
Return on Investment
Residual Income
EVA
W
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Performance Measures -Net Income
N
I
.
E
Net income is generally defined as the revenues of the
investment center less the costs of the investment center.
Where the costs include the allocated costs or overhead.
V
S
S
.B
Strengths:
W
W
Weaknesses:
W
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Performance Measures - ROI
N
I
.
E
Return on Investment is generally defined as the net
income of the investment center divided by some measure
of assets (typically total assets or net assets)
V
S
S
.B
Strengths:.
W
W
W
Weaknesses:
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Performance Measures – Residual Income
N
I
.
E
Residual Income is a variant of ROI. Residual income is
calculated as the investment center’s Net income less a
targeted return times assets (or net assets).
V
S
S
.B
Strengths:
W
W
W
Weaknesses:
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Performance Measures - EVA
N
I
.
E
EVA is basically the same as residual income. There are three
adjustments:
1.
2.
3.
V
S
Accounting earnings are adjusted.
They use WACC, weighted average cost of capital.
Highlights how compensation should be linked to EVA.
S
.B
W
Strengths:
W
W
Weaknesses:
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Canadian Sub (Prob 5-1)
N
I
.
E
See the exercise “Canadian Submarine”: Problem 5-1
in Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 230.
V
S
S
.B
W
W
W
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Quincy’s Insurance
Sometime in the late 1980’s early 1990’s The Bull Dog insurance company stopped selling Major Medical Insurance.
N
I
.
E
V
S
Policies still needed to be serviced.
S
.B
Bull Dog Insurance contracted with Quincy’s to administer
the line of business.
W
W
Quincy’s pays claims, handles complaints, and makes
policy changes.
W
Quincy’s is compensated an annual fee and a bonus. All costs incurred in administrating the book of business are paid by Quincy’s
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Quincy’s Insurance
Quincy’s Bonus has three key ingredients:
N
I
.
E
1. $250,000 based on reduction of claim backlog.
V
S
2. Per file bonus for paying more than the base number of
claims established in the contract.
S
.B
W
3. A bonus based on the size of the book of business.
W
W
What types of behavior does this compensation package
encourage?
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Quincy’s Insurance
N
I
.
E
1. Low skilled laborers.
V
S
2. High Turnover.
S
.B
3. Easy claim payments
W
4. “Super” customer service.
W
W
5. Quality control was done in house, there was no penalty
for poor quality.
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Stale Mart (Prob 5-19)
N
I
.
E
See the exercise “Stale Mart”: Problem 5-19 in Zimmerman,
Jerold L. Accounting for Decision Making and Control (4th Edition).
McGraw-Hill/Irwin, 2002, pp 240-1.
V
S
S
.B
W
W
W
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Controllability Principle
What metric should be selected to evaluate a unit’s
performance?
N
I
.
E
V
S
S
.B
How is the performance evaluation mechanism
affected by random shocks?
W
W
W
Does the performance evaluation system induce
dysfunctional behavior.
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Accounting Information used in transfer pricing
Perfect information vs. Asymmetric information
N
I
.
E
V
S
Types of transfer pricing:
1.
Market Based
2.
Variable Cost
3.
4.
S
.B
W
W
W
Full Cost
Negotiated
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Accounting Information used in transfer pricing
N
I
.
E
Transfer pricing is important to
- Cost Centers
- Profit Centers
- Investment Centers
V
S
S
.B
W
W
W
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Transfer Pricing – Internal Audit
Internal audit is traditionally a cost center.
N
I
.
E
What happens if you allow audit to price its product and charge units?
V
S
S
.B
Key Lessons:
W
- Incentives to be efficient?
- Incentives to consult?
- Potential Disputes?
W
W
Alternatives:
- Compensation for cost cutting and innovations.
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Lewis Corporation (Prob 5-9)
N
I
.
E
See the exercise “Lewis Corporation”: Problem 5-9 in
Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 234.
V
S
S
.B
W
W
W
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Pepsi Co. (Prob 5-17)
N
I
.
E
See the exercise “Pepsi Co.”: Problem 5-17 in Zimmerman, Jerold
L. Accounting for Decision Making and Control (4th Edition).
McGraw-Hill/Irwin, 2002, pp 239.
V
S
S
.B
W
W
W
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Summary
1. Develop an understanding of cost Centers,
profit centers and investment centers.
N
I
.
E
V
S
2. Consider the different means of measuring
performance and the strengths and weaknesses of
each alternative.
S
.B
W
W
3. Develop an understanding of the importance of
transfer pricing within the firm.
W
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Standard Costs – Overview
1. What are standard Costs.
N
I
.
E
2. Why do we set standard costs?
V
S
3. How do we set the standards?
S
.B
4. Calculating Variances: DM and DL
- Disaggregating variances into price and volume.
- Difference between labor and direct materials.
- How do we use variances in evaluating performance?
W
W
W
5.
Calculating Overhead variances.
6.
The incentives created when Standard cost systems are implemented
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Standard Costs
What are standard Costs?
N
I
.
E
Standard costs are the expected costs of manufacturing the product.
V
S
Standard Direct Labor Costs = Expected wage rate X Expected number of hours
S
.B
W
Standard Direct Materials cost = Expected cost of raw materials X Expected number of units of raw material.
W
W
Standard overhead costs = Expected fixed OH + Expected Variable Overhead X Expected number of units to be produced. www.bsscommunitycollege.in www.bssnewgeneration.in www.bsslifeskillscollege.in
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Standard Costs
What is a standard Cost system?
N
I
.
E
A standard cost system is a method of setting cost targets and
evaluating performance.
V
S
Targets or expected costs are set based on a variety of criteria, and
actual performance relative to expected targets is measured.
S
.B
W
Significant differences between expectations and actual results are
investigated.
W
W
Consistent with the themes developed throughout this class, standard
cost systems are a means of helping managers with decision making
and control.
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Standard Costs
Target Costing
N
I
.
E
1. The market place determines the selling price of the
future product
V
S
S
.B
2. The company determines the profit margin they desire
to achieve on this product.
W
W
3. The difference between the selling price and the profit
margin is the target cost
W
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Standard Costs
Why use a standard cost system?
1. Standards are important for decision making
- How we produce our product.
- How we price our product.
- Contract billing
N
I
.
E
V
S
S
.B
W
2. Monitor manufacturing
- Large variances may indicative of problems in production.
W
W
3. Performance measurement
- Deviations between actual and standards are often used as
measures of a manager’s performance
- Who sets the standard?
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Standard Costs
How do we set the standards?
N
I
.
E
Theoretically the standard should be the expected cost of producing the
product.
V
S
S
.B
General practices:
1. Prior years performance
2. Expected future performance under normal operating
conditions.
3. Optimistic (Motivator)
W
W
W
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Standard Costs
Important considerations in setting standards:
N
I
.
E
1. Why are senior managers using standards? - Pricing
- Performance measurement
- Production decisions
V
S
S
.B
2. What happens if managers fail to meet the standards?
W
W
3. Standards are supposed to represent the opportunity cost of
production.
W
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Standard Costs
Consider the following information on Beer manufacturing:
N
I
.
E
Expected DM and DL for producing 1000 gallons of beer
Standard Quantity
S
.B
Raw Materials:
Wheat
100 lbs
Hops
200 lbs
Barley
200 lbs
Direct Labor
Total
W
W
W
500 hours
V
S
Standard Price
Total
$50.00 per pound
5000
$50.00 per pound
10000
$50.00 per pound
10000
$20.00 per hour
10000
35,000
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Standard Costs
Actual results associated with the purchase of 1000 gallons of beer
Quantity
Purchased
Quantity used
in Production
Wheat
100 lbs
100 lbs
Hops
300 lbs
Barley
500 lbs
V
S
Raw Materials:
Direct Labor
Total
W
S
.B
Total
$55.00 per
pound
5500
150 lbs
$50.00 per
pound
7500
250 lbs
$40.00 per
pound
10000
550 hours
$22.00 per hour 12100
W
W
N
I
.
E
Materials and
labor price
35100
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Standard Costs
Raw Material Price Variance:
N
I
.
E
Raw Materials
Actual
price
Standard
Price
Quantity
Variance Purchased
Total
Variance
Wheat
?
?
?
? lbs
?
Hops
?
?
? lbs
?
Barley
?
?
? lbs
?
S
.B
V
S
?
?
W
W
W
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Standard Costs
Raw Material Quantity Variance:
Raw Materials
N
I
.
E
Quantity
Used
Standard
Quantity
Variance
Standard
Price
Wheat
? lbs
? lbs
?
?
Hops
? lbs
? lbs
Barley
? lbs
? lbs
S
.B
V
S
?
?
Total
Variance
?
?
?
?
?
W
W
W
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Standard Costs
What do we do with the raw materials price
variance?
N
I
.
E
V
S
Who do we hold responsible?
S
.B
W
What do we do with the raw materials quantity variance?
W
W
Who do we hold responsible?
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Standard Costs
Direct Labor Wage Variance:
Direct Labor
N
I
.
E
Actual
price
Standard
Price
Actual
Variance Hours
Total
Variance
22.00
20.00
2.00
$1100.00
S
.B
V
S
550
W
W
W
There is a $1100 unfavorable wage variance
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Standard Costs
Direct Labor Efficiency Variance:
Direct Labor
N
I
.
E
Actual
Hours
Standard
Hours
Standard
Variance rate
Total
Variance
550
500
50
$1000.00
S
.B
V
S
20
W
W
W
There is a $1000 unfavorable Efficiency variance
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Arrow Industries (problem 12-3)
N
I
.
E
See the exercise “Arrow Industries”: Problem 12-3 in
Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 624-5.
V
S
S
.B
W
W
W
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Howard Binding (Problem 12-16)
See the exercise “Howard Binding”: Problem 12-16 in
Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 630.
N
I
.
E
V
S
S
.B
W
W
W
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Standard Costs
There are three types of overhead variances that are commonly computed in standard
cost systems. Before we describe each of these variances we need to do a brief review
on overhead.
1. Overhead consists of both fixed costs and variable costs.
N
I
.
E
V
S
2. Overhead is allocated to the product using an activity base.
S
.B
Thus overhead variances can occur for three reasons
W
W
1. the activity base estimate is different than the actual activity base.
2. The amount spent for fixed overhead differs from the standard.
3. The amount spent on variable overhead (the rate per unit) differs from the standard.
W
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Standard Costs
Overhead spending variance
N
I
.
This variance is designed to measure
how
much
E
overhead was actually incurred compared
to the
V
Sincurred at the
overhead that should have S
been
B base.
actual volume for the .activity
W
W = Actual overhead – budgeted
Spending variance
fixed costs
W– budgeted variable overhead
allocation rate * actual activity base.
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Standard Costs
Overhead efficiency variance
N
I
.
This variance is a measure of the effect
of the
E
difference in the amount of an activity
base
V
S
incurred compared to the expected
amount of the
S
activity base.
.B
Using additional W
machine hours or direct labor
hours causesW
additional variable overhead
Wvariance = Variable overhead
Efficiency
allocation rate * ( actual activity base – budgeted
activity base)
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Western Sugar (Problem 13-9)
N
I
.
E
See the exercise “Western Sugar”: Problem 13-9 in Zimmerman,
Jerold L. Accounting for Decision Making and Control (4th Edition).
McGraw-Hill/Irwin, 2002, pp 660-1.
V
S
S
.B
W
W
W
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Standard Costs
Overhead volume variance
N
I
.
E
The overhead volume variance measures the cost or benefits of using less or
more than expected capacity.
V
S
S
.B
Volume Variance = Fixed Overhead *(Budgeted volume – actual volume)
budgeted volume
W
W
If budgeted volume = actual volume, then you have derived no extra benefits
or costs associated with capacity.
W
When budgeted volume is less than expected volume, then the fixed costs
associated with providing capacity are greater than expectations
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Standard Costs
When standards are used to measure performance, then the manager has an
incentive to insure production costs come in below standards. Consider the
following good and bad incentives:
N
I
.
E
1. Direct Material Price standards create the incentive to purchase materials in
large volume to get price discounts.
V
S
S
.B
2. Direct Material Price standards create the incentive to reduce the quality of
the material purchased.
W
3. Standards create the incentive for cross monitoring. When managers are
held responsible for costs that are outside of their control, they will monitor
other managers to ensure they meet standards.
W
W
4. Managers also have the incentive to control costs so long as they do not
exceed the standard. No incentive to reduce costs below standard.
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Standard Costs
What controls can you implement to discourage
the harmful incentives and encourage the
productive incentives?
N
I
.
E
V
S
S
.B
Just-in-time inventory
System of Quality Control
Engineering specifications
Controllability of Costs
Non-linear reward system for cost reduction.
W
W
W
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Activity Based Costing
How do we use Activity Based Costing?
N
I
.
E
1. Costs are accumulated in activity centers (a.k.a. Cost Centers such as order
processing or special components)
V
S
2. Managers select an activity base for the center to apply the cost to the product.
S
.B
- Multiple cost drivers in the firm
- Use non-financial measures to reduce the tax on production activities.
- Four Basic types of Cost Drivers:
1. Unit level
2. Batch Level
3. Product Level
4. Production Sustaining Costs
W
W
W
3. Costs are allocated to the product as the product passes through the activity center.
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Activity Based Costing
What are the benefits of using Activity Based Costing Systems?
N
I
.
E
1. More costs are traced to the product.
V
S
2. Activity Based Costing Requires managers to obtain a better understanding
of:
-
S
.B
How costs are consumed by individual products.
The different activities that produce products.
The indirect costs associated with these activities.
How indirect costs relate to cost drivers.
W
W
W
3. Product costs are more accurate.
Proponents argue that having more accurate costs will help in decision making
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Activity Based Costing
Key Points regarding Activity Based Costing:
N
I
.
E
1. Useful for developing a more accurate measure of the cost of
multiple products with different levels of manufacturing sophistication
and different volumes of production.
V
S
S
.B
2. Managers must recognize that overhead varies by factors other than
volume of production for the product.
W
3. The managers ability to successfully identify these cost drivers will
ultimately determine the usefulness of an ABC costing system.
W
W
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Activity Based Costing
What are the costs of implementing an Activity Based Cost system?
N
I
.
E
1. Updating the accounting system and maintaining an ABC system requires
additional time and money.
V
S
S
.B
2. Managers select cost drivers in their activity centers. There is a tradeoff
between decision making and control.
W
3. While ABC systems may more accurately measure costs, they ignore the
benefits of a multi-product production strategy.
W
W
4. Generally ABC system demonstrate that low volume products are more
costly to produce than high volume products. This is a very costly method to
derive this result.
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Overview
1.
2.
3.
4.
5.
6.
The Economics of Organizations
Finish up the problems from last class
Key assumptions and important concepts underlying the
analysis of how managers can better motivate and
control behavior.
Measuring and Evaluating Performance
Allocating Decision rights
Integration
Summary
N
I
.
E
V
S
S
.B
W
W
W
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Emrich Processing
N
I
.
E
See the exercise “Emrich Processing”: Problem 2-11
in Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 75-6.
V
S
S
.B
W
W
W
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Problem – Corporate Jet Co.
A firm with three divisions has two facilities, one in
Chicago, one in Orlando.
N
I
.
E
V
S
Everyday some of the executives in the Chicago
office fly to the Orlando office, and others return.
The Company is considering buying their own jet.
S
.B
W
What are the factors
the firm must consider in their
W
decision to purchase the jet?
W
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Agency Costs
Most economic models assume people attempt to
maximize their well being (known as utility).
N
I
.
E
V
S
Agency Problem: Agents will undertake actions to
maximize their utility regardless of whether their actions
maximize profits.
S
.B
W
W
W
Moral Hazard - Insurance
Adverse Selection - Hiring/fuse
Short Horizon - project selection
Free rider - Group Projects
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Napster
File Sharing community to allow a group of
individuals to share files through the internet.
N
I
.
E
V
S
The current innovation in this technology is
known as Gnutella.
S
.B
W
It is a form of peer-to-peer technology.
W
W
How can peer-to-peer technology be designed to
reduce their agency problems?
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Free Riders
How do firms reduce the costs associated with free riders?
N
I
.
E
In a multidivisional firm, there are often “public goods” provided by
the main headquarters to all of the divisions. How does the firm
discourage free riders and the over use of the common good?
-
Copy centers
Building space
Human resources
Parking spaces
Capital
V
S
S
.B
W
W
W
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University Physician (Prob 4-6)
See the exercise “University Physician”: Problem 4-6
in Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 182.
N
I
.
E
V
S
S
.B
W
W
W
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Private Country Clubs (P4-16)
N
I
.
E
See the exercise “Private Country Clubs”: Problem 4-17 in
Zimmerman, Jerold L. Accounting for Decision Making and
Control (4th Edition). McGraw-Hill/Irwin, 2002, pp 185-6.
V
S
S
.B
W
W
W
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The Equitable
Mutual Insurance Company until 1993. Was a member of
the Fortune 100.
N
I
.
E
Ownership of the company is maintained by the
policyholders.
V
S
S
.B
This means no single person owns a significant interest in
the firm (no traded equity either)
W
W
What are some of the problems that are likely to arise from
the mutual form of organizational structure?
W
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Agency Costs
What are the factors that limit the agency costs a firm
will incur?
N
I
.
E
1. The principle’s ability to monitor and thereby control
the agent
V
S
Monitor until:
S
.B
W
W
Marginal Costs > Marginal Benefits
W
How can the firm’s internal accounting system be used
to monitor the agent?
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Agency Costs
Consider Michael Eisner’s 1996 employment contract with Disney:
N
I
.
E
V
S
1. 10 year contract
2. Base salary of $750,000
3. Bonus based on Disney meeting targeted
EPS.
4. Stock Options on 8 million shares of stock
extending a period of 15 years.
S
.B
W
W
W
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Agency Costs
Other Factors that limit the Agency costs of the firm:
- The market for corporate control.
N
I
.
E
V
S
S
.B
- The competitiveness of the labor market.
W
- External Competition.
W
W
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Decision Rights
For a team to produce more efficiently than each of the
individuals, decision rights must be allocated among the
members of the team.
N
I
.
E
V
S
S
.B
When the owner allocates decision rights, she must
consider the following:
W
W
1. Shirking
W
2 Influence Costs
3. Separation of decision making and
decision control.
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Decision Rights and Accounting Systems
How is accounting information important in the allocation
of decision rights?
N
I
.
E
V
S
The principle should implement controls within the
accounting system to reduce the costs associated with
allocating decision rights. For example:
S
.B
W
• Requiring competitive bids on purchases over a certain
dollar amounts.
• Requiring approval of purchases over certain dollar
amounts.
• Measuring firm performance that is reflective of
managerial effort.
W
W
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Priceline.com
What is priceline.com?
N
I
.
E
V
S
Why doesn’t Delta replicate priceline.com on their
own ?
S
.B
W
W
Why did priceline.com work for airplane tickets
and not for supermarkets or gas sales?
W
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Value Added Retailing
AT&T is in the business of providing phone service.
N
I
.
E
One division provides phone lines for internet retailers or providers.
V
S
These companies typically need reliable connections to the WEB and
costly equipment to provide these services.
S
.B
AT&T has three divisions that jointly handle these transactions:
- Sales department for telephone lines
- Installation unit
- Billing department for both groups
W
W
W
What are some of the problems with this organizational design?
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Markets vs. Firms
N
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When do transactions get conducted inside the firm vs. in a
competitive market?
V
S
For a firm to survive, it must be less costly to internally
produce the good than going to an external market.
S
.B
W
Consider the following 2 examples:
W
Priceline.com
W
Value added retailing
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The Role of Accounting in Organizational Architecture
N
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Accounting systems role within the firm.
1.
2.
V
S
S
.B
Performance Measurement
W
W
Performance Evaluation
W
3.
Allocation of Decision Rights
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Summary
1. Refresher on organizational problems
within the firm
N
I
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E
V
2. Managerial accountingSplays an
S
important role in reducing
B agency costs.
.
- Motivate employees
W
W behavior
- Control their
W
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Final Exam
Weber’s Customized Electronics
Overview
Weber’s Customized Electronics was founded in 1990. T.J. Weber, an engineer with 20
years in the airline industry, founded the company. The company initially supplied
customized electronic components to the military. As the company prospered, the firm
expanded by purchasing some of their competitors, and bidding on outsourced business
from the commercial airline industry.
By April 2002, Weber’s had become a multidivisional corporation (twelve in total)
producing a variety of customized electronic components for the airline and automobile
industries as well as the military.
N
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.
E
The Electronics Testing Division (ETD) is one of the twelve divisions. ETD provides
centralized testing for the electronic components produced in the other 11 divisions.
ETD was created in 1997 as a result of a strategic reorganization of the company. As
Weber’s expanded in the 1990’s each division separately employed various machinery
and personnel to test the integrated circuits (I.C.’s), diodes, transistors, capacitors,
resistors, transformers, relays and crystals that were used in the various products. The
costs of the machinery and the personnel in each division were substantial, and
management believed that consolidating testing into one central division that serviced the
other eleven divisions in the corporation would result in substantial cost savings.
V
S
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.B
W
ETD was organized as a cost center. The other eleven divisions would provide products
to the division to be tested, and the costs of testing these products were transferred back
to the divisions at full cost (direct labor cost and allocated burden for overhead, there are
no direct materials used in this division). Although ETD is a captive division, the other
divisions in Weber’s were allowed to use outside testing services if ETD could not meet
their cost or service requirement. Furthermore, ETD was permitted to use 20% of their
capacity to test the circuits, diodes, transistors, capacitors, resistors, transformers, relays
and crystals of outside companies.1 The department has no budget for advertising or
marketing services, thus most outside customers were obtained by word of mouth.
W
W
ETD employed approximately 65 hourly personnel and 40 administrative and technical
staff members. Budgeted expenses were 7.9 million in 2002 (See Exhibit 1)
Testing Procedures
ETD had tested 30 million components in 2001 and expected to test between 35 and 40
million components in 2002. Component testing was required for two reasons. First, if
defective components were not caught early in the manufacturing cycle, the cost of repair
could be substantial. Studies indicated that a defective capacitor caught before its use in
1
The division was expected to make a 15% profit margin on outside business.
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the manufacturing process, cost two cents to repair. If the defect was not caught until the
product was out in the field, the costs of replacing the capacitor could run in to the
thousands of dollars, greatly exceeding the cost of the electronic component. Second, a
large proportion of Weber’s work was defense related. Military specifications frequently
required extensive testing of components used in aerospace and naval products. By 2002,
ETD had the ability to test 6500 different types of components. Typically the division
would test 500 different components a month and between 3000 and 3500 different
components per year. Each division or outside customer would send components to ETD
in lots. ETD would then test each lot and the defective pieces would be identified and
separated for retooling. In 2002, ETD expected to receive 12,000 lots of components.
ETD performs both electrical and manufacturing testing. Electrical Testing involves
measuring the electrical characteristics of the components and comparing these
measurements with the component’s specifications. For example, the specifications of an
amplifier may have called for a 1-volt input to be amplified into a 10-volt output. ETD
would deliver a 1-volt charge to the amplifier, and then measure whether the amplifier’s
output was in conformance with specifications.
N
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Mechanical testing included solderability, component burn-in, thermal shock, lead
straightening and leak detection. Solderability involved the inspection of components to
ensure they held solder. Burn-in involves the extended powering of components at high
temperatures. Thermal shock involves the cycling of components between high and low
temperatures. Lead straightening was the detection and correction of bent leads on
components. Leak detection involved the examining of hermetically sealed I.C.s for
leaks.
V
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.B
W
Components varied significantly in the number and the type of electrical and mechanical
testing procedures they required. This variation resulted in about 200 different standard
process flows for the division. One manager in the division was responsible for
determining the process flows in the facility. He organized the monthly testing runs
based on the different combinations of tests and specifications the customer requests.
Based on these combinations, he would determine the routing of the product between
testing equipment and the type of tests performed at each station. I.C.s, for example,
could follow up to twelve different flows through the facilities. Some of the I.C.’s only
require electrical testing at room temperature; others required solderability and leak
detection as well as thermal shock and burn-in tests.
W
W
Each type of component required separate software development, custom tools, and
occasionally custom fixtures were also required. Software, tools, and fixtures were
developed by the engineering group, which was made up of specialists in software
development, equipment maintenance, calibration and repair, tooling and fixturing, and
testing operation. Software engineers developed programs for specific applications. The
programs were then retained in the software library for future use. During 2002 ETD has
added another 1300 software programs to the library, increasing the total in the software
library to over 6500 different software programs. ETD also had an inventory of 1500
tools and fixtures, of which 300 had been developed in the past year. The large number
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of tools and fixtures allowed the testing of components with a variety of leads, pin
combinations, and mating configurations.
ETD monitored the costs and the processes that were necessary to test the various
components Weber’s produced, and they often compared their costs to bids from their
competitors. On complex parts that require screening, environmental conditioning, the
division was consistently cheaper than outside vendors. Where only elementary testing
was required, low technology outside laboratories were often cheaper, especially on large
lots. The division manager at ETD, Susan Swampscott, believed that the advantage that
the division brought customers over the outside labs was that the latter had almost no
engineering support, while ETD has engineering resources available to quickly design
and implement tests on complex parts in a cost-effective manner. The shift to more
technically sophisticated services has prompted a shift in the labor mix from direct to
indirect personnel. The division expected to see a crossover between engineering head
count and hourly headcount some time in the next three years.
N
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The testing facility was divided into three rooms. The stock room housed administrative
personnel, and also was designed for receiving incoming components for testing, and for
sorting outgoing products that had already been tested. The main testing room contained
the equipment used for electrical testing. The mechanical room contained the equipment
used for mechanical testing. 30 people worked in the mechanical room and another 30
people worked in the main testing room. The remaining 5 people worked in the stock
room.
V
S
S
.B
Recently there had been some innovations at Weber’s that were likely to affect the testing
of components. First, Weber’s has been moving towards producing high-technology
components, creating the need for automatic testing on sophisticated equipment.
Automatic testing will lead to longer test cycles and more data per part. For example,
digital components are currently tested for up to 100 conditions (a condition is a
combination of electrical input and output state). The new generation of digital
components is so much more complex that they require the verification of up to 10,000
conditions. These components require expensive highly automated equipment and less
direct labor to complete the tests.
W
W
W
Second, in 2002, Weber’s adopted a Just-in-Time inventory system for all of its divisions.
As part of the adoption of this system, Weber’s implemented a vendor certification
program, where Weber’s engineers verified that vendor’s production process would result
in pieces of components that met required engineering specifications. As each division
determines which of their vendors must be certified, the testing of some of the pieces of
Weber’s electrical components will be pushed back to the vendor. ETD was expecting to
move from the primary tester of several components to a quality inspector of these
components. Thus instead of testing every component in a lot, ETD would use statistical
sampling and test a percentage of the components to insure that the vendors supplied
pieces that met the firms engineering standards. Early indications suggest that the JIT
system will lead to an increased number of smaller lots being received by ETD, and
vendor certification will reduce the number of tests that ETD will have to perform. ETD
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forecasts that over the next three years, 30% of the products produced by Weber’s will
have been initially tested by certified vendors.
Cost Accounting System
The cost accounting system measures two components of cost: Direct Labor and
Overhead. The Overhead costs were accumulated into a single cost pool. All of the
overhead costs associated each of the testing rooms, the stock room, and the costs of
engineering, software development, and tooling/fixtures development were accumulated
in this pool. Total overhead costs were divided by the sum of testing and engineering
labor dollars to arrive at a burden rate per direct labor dollar. The division costed each lot
of components. The overhead allocated to each lot by multiplying the actual direct labor
dollars associated with the lot by the burden rate. Thus the total cost associated with
testing a lot of components is the sum of the direct labor and overhead. In 2002, the
facility wide burden rate was 145% of each direct labor dollar. (See Exhibit 1 for a
description of the overhead costs, and the calculation of the burden rate for 2002.)
N
I
.
E
Current Events
In April 2002, Stacy Swampscott, the manager in charge of ETD, was reviewing the
results for the division for the first quarter. She realized that this was the second
consecutive quarter in which the Aerospace division had reduced the number of
components they had sent to ETD for testing. She assigned her assistant manager, Fred
Dusseldorf, to find out why aerospace was reducing their use of ETD. Fred had
determined that Aerospace was outsourcing testing for some of their components.
Furthermore, the division manager of the military department in Weber’s had recently
suggested that they might outsource some of their testing because ETD’s costs were
getting a little high. The manager of the Aerospace division had complained to Fred that,
“I do not know what you all are paying your people over there, but ABC labs came in at
25% of your cost.”
V
S
S
.B
W
W
W
This seemed strange to Susan. Just this quarter, the department had won an external bid
for testing components for a defense contractor, Spellman Industries, that does not
compete with Weber’s. When her production manager, Hank Kellog, had prepared the
estimate for the costs of the new job, he had determined that testing on this product
would require that the department purchase another machine, that would cost the
department approximately $2,000,000. However, similar to the last two external testing
jobs, the testing on this component was almost entirely automated, direct labor costs were
estimated to be less than $50,000, handling costs were estimated to be less than $15,000,
and other engineering and overhead costs associated with this job were expected to be
less than $100,000. He also determined that after the job was completed, the machine
could be retooled and used to help test some of the military parts for which testing was
currently outsourced. Since the machine could be used to test other products in Weber’s,
her assistant prepared the bid by calculating a revised cost estimate using the 2002
budget, and applying a 20% margin to those costs.
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She decided it was time to have a meeting with Fred and Hank to see if she could
determine what was happening with the division’s costs. Since the aerospace division
manager was complaining about her direct labor costs, she asked Fred to analyze the
departments labor costs over the last two years focusing on the direct labor costs for
aerospace components (Exhibit 2), and she asked Hank to bring his estimates for the bid
the department had recently won (Exhibit 4).
The Meeting
Fred: Well Susan, I talked to Ross Watts, the manager in charge of process flows, and I
thought we might be onto something by analyzing the labor costs of testing electronics
components of the Aeronautics division. Ross indicated that we were testing about
60,000 units a month for this division, and that the testing of Aeronautics Components is
mostly a manual process, done on simple machines, and require relatively more direct
labor hours.
N
I
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E
So the first thing I did was investigate whether the increase in the union rates was larger
than we had anticipated. As you can see from this graph (Exhibit 2), last March the line
personnel got a 3% raise, so I don’t think the slight increase in the wage rate is the
driving factor in the difference between our costs and our competitors.
V
S
I also looked at the direct labor costs for testing the Aeronautics components. In total, the
costs look relatively stable at about $10,000 per month until the 4th quarter of 2001. Then
they outsourced the Fetzner boards to ABC LABS, and in January they outsourced the
splintners circuits. Thus the direct labor costs associated with testing Aeronautics
electronic components dropped.
S
.B
W
I also checked the Dl$ per unit tested, and compared it to the average DL$ per unit tested
for the company. As you can see in this third graph, the Dl$ per unit tested is higher than
the average unit tested in the company, but it is very stable and actually decreasing
slightly for the products we test in this division. We implemented a slight change in the
process flow that allowed laborers to handle more units per hour. I just don’t think our
labor costs are the source of the problem. Maybe the costs of our overhead have
increased? Or perhaps ABC LABS has figured out a way to do this better?
W
W
Susan: I was afraid that it wasn’t the direct labor costs Fred. I went and looked at the
direct labor costs for our entire department, and they look like they have are expected to
go down this year as we bring on more of these automated testing machines. I also
looked at the total overhead for the department, and total cost of the department and I
don’t see much of a change (See Exhibit 3). Since I don’t see a large percentage change
in costs, our competitors must have made some technological improvement in how they
test these electronic components.
Susan: What amazes me is that we seem to be losing some of our divisions as customers
but external customers seem to find us to be the low cost bidder. Hank, how did we
determine the cost to charge Spellman for their components?
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Hank: Well Susan, let me give you some of the basics. First, we are going to be testing
about 1,200,000 components a year for Spellman. The machine can handle 30,000
components a week at full capacity, so I figure that we are going to use 80% of the
machines capacity running the Spellman job.
In determining a rate to charge Spellman, I figured that since we were going to use 20%
of the machines capacity on internal orders, the best thing to do was to estimate the costs
of adding the Spellman business and then revised the budget to include the expected cost
of the Spellman job. (See Exhibit 5) I figure Spellman will use $50,000 in direct labor
costs. Some of these costs will be from hiring an additional part time worker, and some
of these costs will be from using the excess capacity created when we lost our
Aerospace’s components. I also estimated additional overhead associated with this job to
be $315,000 and the new burden rate is 1.533, so I come out with total costs of about
$126,000. I then used a margin of 20%, and I come up with revenues of $151,200.
When I divide this by the 1,200,000 units, I get a rate of 12.6 cents per component tested.
I rounded up to 13 cents a unit.
N
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E
I also analyzed how this job will affect the machine hours available for testing. As you
can see from this exhibit, we had 33,201 hours in the main room, and 17,203 hours of
machine time in the mechanical testing room. The new machine will annually provide an
additional 2000 hours of testing time to the Mechanical room, since all the tests on the
Spellman components will be done there. This year I expect the Machine will be used
exclusively on the Spellman job. In the future we will have 400 hours of excess capacity
to take on additional work.
V
S
S
.B
W
Susan: Hank, that seems reasonable to me. I’m lost as to how we can be beating our
competitors in one set of tests and losing in the other. Perhaps we need to bring in an
expert to figure this out. Fred, why don’t call that consultant that just graduated from
Sloan maybe she/he can help us.
W
W
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Exhibit 1
Panel A: Estimates of Direct Labor and Overhead costs for the ETD Division
2002 Budgeted Expenses
Direct Labor
Overhead:
Indirect Labor
859,242
Salary Expense
394,211
Supplies and Expenses
538,029
245,226
Services2
Personnel Allocations3
229,140
Service Allocations4
2,448,134
Total Overhead Expenses5
Total Budgeted Expenses
Expected profits from
servicing external
customers6
Burden rate = (4,713,982)/(3,260,015) = 144.6%
$3,260,015
4,713,982
$7,973,997
N
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E
$300,000
V
S
S
.B
W
W
W
2
Includes Tool Repair, Computer expenses, Maintenance Stores, and service cost transfers from other
divisions
3
Includes the costs of indirect and salaried employees fringe benefits, the personnel department, security,
stores/warehousing, and holidays/vacations.
4
Includes Building occupancy, telephones, depreciation, information systems, and data control.
5
The cost accounting department estimates that $1,426,317 of the overhead costs is variable, $1,288,000 of
the costs is related to depreciation, and the remaining $1,999,665 is other fixed costs. Breakouts of these
costs are provided in Panel A
6
ETD is a cost center, the transfer price to the other divisions is full cost. Thus for all of the testing done
on Electronic components produced by divisions within Weber’s the expected revenues for ETD is equal to
expected costs. For ETD’s external customer’s, the division is expected to markup the costs by 15% to
determine the selling price of their service. Any profits above the 15% margin are allocated to a profit
sharing pool for the senior managers of the division. For Fiscal 2002, the average margin for servicing
outside customer is expected to be 20%, expected profits on external customers is $300,000 and $75,000 is
expected to be available for profit sharing.
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Exhibit 1
Panel B: Budgeted Overhead Expenses for each of the three rooms in the ETD Division
for 2002
Main Test Room
Mechanical Test
Room
Total for Test
rooms
Engineering,
admin and storage
Total Costs
Variable
Depreciation
88,779
Other Fixed
Costs
1,126,958
Total
Costs
2,103,116
887,379
443,833
808,103
674,327
1,926,263
1,331,212
896,882
1,801,285
4,029,379
95,105
1,426,317
391,118
1,288,000
198,380
1,999,665
684,603
4,713,982
N
I
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E
V
S
S
.B
W
W
W
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Exhibit 2
Analysis of Average hourly wage rate per direct labor hour for the employees in the
Electronics Testing Department.
Wage
8.4
8.3
8.2
8.1
Wage
8
7.9
7.8
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Ap
r- 0
0
Ju
n0
Au 0
g0
O 0
ct
-0
D 0
ec
-0
Fe 0
b0
Ap 1
r- 0
1
Ju
n0
Au 1
g0
O 1
ct
-0
D 1
ec
-0
Fe 1
b02
7.7
V
S
S
.B
Analysis of Direct Labor Cost of testing Aeronautics Electronic components
W
Dl$
W
12000
10000
8000
W
6000
Dl$
4000
2000
Ap
r-0
0
Ju
n0
Au 0
g0
O 0
ct
-0
0
D
ec
-0
Fe 0
b0
Ap 1
r-0
1
Ju
n0
Au 1
g0
O 1
ct
-0
1
D
ec
-0
Fe 1
b02
0
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Exhibit 2
Analysis of average direct labor cost per electronic component tested for the Aeronautics
Division compared to the average direct labor dollar per unit for the entire ETD
department.
Direct labor dollars per unit tested
0.18
0.175
0.17
0.165
0.16
0.155
0.15
0.145
0.14
0.135
0.13
0.125
0.12
0.115
0.11
0.105
0.1
0.095
0.09
0.085
0.08
N
I
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Aerospace
entire department
Feb-02
Dec-01
Oct-01
Aug-01
W
W
S
.B
Jun-01
Apr-01
Feb-01
Dec-00
Oct-00
Aug-00
Jun-00
Apr-00
V
S
W
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Exhibit 3 Comparison of 2001 Actual results and 2002 budget
2001
Actual
2002 Budget
Percentage
Change
Direct Labor
Overhead:
Indirect Labor
Salary Expense
Supplies
and Expenses
Services7
Personnel
Allocations8
Service
Allocations9
Total Overhead
$3,766,012
$3,260,015
-13.4%
811,028
320,045
602,230
859,242
394,211
538,029
+5.9%
+23.1%
246,006
245,226
243,498
2,275,034
229,140
2,448,134
4,497,891
4,713,982
Total Expenses
8,263,903
$7,973,997
-10.6%
-0.3%
S
.B
V
S
N
I
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E
-5.8%
+7.6%
+4.8%
+3.5%
W
W
W
7
Includes Tool Repair, Computer expenses, Maintenance Stores, and service cost transfers from other
divisions
8
Includes the costs of indirect and salaried employees fringe benefits, the personnel department, security,
stores/warehousing, and holidays/vacations.
9
Includes Building occupancy, telephones, depreciation, information systems, and data control.
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Exhibit 4
Panel A: Cost analysis of Purchasing new machine to test Spellman’s Electronic
Components
Cost of Purchasing Unibridge E34r capicitor flux testor
Cost of New Machine
$2,000,000
10
Depreciation Rate
$200,000
Direct Labor Costs11
$50,000
Handling Costs
$15,000
Engineering Salary
$25,000
Other Overhead Charges
$75,000
N
I
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E
Panel B: Effect of purchasing E34r Capacitor Flux Testor on available machine hours for
testing
Main Test Room
Mechanical Test
Room
Total
Expected total
Machine Hours for
2002
33,201
Revised 2002
estimate of machine
hour capacity
33,201
1,500
1,500
18,603
52,304
S
.B
W
17,103
50,304
V
S
Capacity
provided by E34r
Capacitor Flux
Testor12
0
W
W
10
Depreciation is done over 10 years on a straight-line basis assuming no residual value.
Instead of bringing in an additional full time employee, the division will hire a part time employee for
approximately $20,000 per year, the rest of this cost will be from the excess capacity that we have from
losing the testing of Aerospace products.
12
Since the Machine is being purchase in April, only 75% of the machine’s annual capacity is available. In
addition all of the 1500 hours will be used on testing the external product.
11
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Panel C: Revised Budget including the costs of doing the Spellman job Revised Budget
Direct Labor13
Overhead:
Indirect Labor
Salary Expense
Supplies
and Expenses
Services14
Personnel
Allocations15
Service
Allocations16
Total Overhead
Total Expenses
Additional Costs
of E34r Capacitor
Flux Testor
2002 Budget
Revised
Budget
$20,000
$3,260,015
3,280,015
0
25,000
859,242
394,211
859,242
419,211
0
25,000
538,029
245,226
538,029
260,226
15,000
229,140
250,000
315,000
335,000
2,448,134
4,713,982
7,973,997
V
S
N
I
.
E
244,140
2,698,134
5,028,982
8,308,997
S
.B
Revised Burden Rate = 5,028,982/3,280,015 = $1.533 per direct labor hour
W
W
W
13
Instead of bringing in an additional full time employee, the division will hire a part time employee for
approximately $20,000 per year, the rest of this cost will be from the excess capacity that we have from
losing the testing of Aerospace products.
14
Includes Tool Repair, Computer expenses, Maintenance Stores, and service cost transfers from other
divisions
15
Includes the costs of indirect and salaried employees fringe benefits, the personnel department, security,
stores/warehousing, and holidays/vacations.
16
Includes Building occupancy, telephones, depreciation, information systems, and data control.
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Exhibit 5
Representative data on the costs and machining time for 1 lot of 10,000 components for 5
different components tested at ETD
Product
ICA
ICB
Capacitor
Amplifier
Diode
Direct Labor
Dollars
917
2,051
1,094
525
519
Main Room
Machine Hours
Mech. Room
Total
8.5
14.0
3.0
4.0
7.0
10.0
26.0
4.5
1.0
5.0
18.5
40.0
7.5
5.0
12.0
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Questions
Consider yourself to be the consultant that ETD hires to come help them address the
problems that the division is facing. Prepare a report to Susan that highlights the
problems that Weber’s currently has and proposed solutions. In your report you should
address the following questions.
1. What are the important issues in the ETD division of Weber’s Electronic Components? How would you predict the problems in the ETD division would affect the other divisions in Weber’s?
2. What steps would you suggest ETD implement to rectify these problems? What are
the advantages and disadvantages of your proposed system? What other information
would you need to help in your recommendation?
3. Exhibit 5 provides data on 5 representative products. What are the costs of the 5
representative products in the current system? What will the costs be when the firm
takes on the Spellman job? If you have proposed any changes to the cost accounting
system, what are those changes, and what are the costs of these products under your
system?
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4. How profitable do you think the Spellman job will be? What price would have you
charged to make a 20 percent margin? Does the excess capacity that the machine
provides affect your analysis? How?
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5. Susan also asks that you include a section in your report that provides suggestion for
changes in ETD and/or in the firm that could be provided to the CEO.
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Remember be clear and concise in your write up. If you need to make any additional
assumptions, then be explicit in identifying your assumptions. Please provide schedules
supporting any calculations you make. If you elect to email me your solution, your entire
write up must be contained in a single, printer friendly document.
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** This document refers to a case from Harvard Business School.
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